Apocalypse Averted

Published on October 6, 2020

Bauer Research Looks at Implications of COVID on Dodd-Frank Act Derivatives

Eight years ago, C. T. Bauer College of Business Finance Professor Craig Pirrong wrote an article challenging conventional wisdom about the Dodd-Frank Act that was published in the Journal of Applied Corporate Finance (JACF).

Pirrong, whose research focuses on the economics of derivatives markets and risk management, revisited the subject in a recently published JACF article, “Apocalypse Averted: The COVID-Caused Liquidity Trap, Dodd-Frank, and the Fed.”

(In the original article), “I challenged the conventional wisdom that a major feature of the Dodd-Frank Act—the one that required clearing of most over-the-counter (“OTC”) derivatives and collateralization of those that cannot be cleared—would materially reduce the risk of another financial crisis,” Pirrong writes.

The dramatic financial fallout from the spread of COVID-19 in March 2020 provided the first major test of his theory as the economic infrastructure of the U.S. was rattled by extreme stock market fluctuations and other substantial disruptions Pirrong describes in detail in the paper.

According to Pirrong, “The very mechanism that advocates of Dodd-Frank claimed would reduce systemic risk—the margining of derivatives—played a major role in acute market dislocation.”

“A policy tool that has historically been advanced as a means of constraining leverage-based trading strategies (such as basis trading)—namely, margins—(is) not sufficient to end the problem. Indeed, they may have contributed to it by exacerbating stresses on market liquidity.”

“Protecting an important piece of the system is different from protecting the system itself; and, in fact, these goals can prove to be antithetical,” he writes.

Pirrong’s paper goes on to say that “Federal Reserve intervention in the form of massive injections of liquidity, rather than the autonomous operation of market infrastructure, is what stemmed the crisis. The episode proves, therefore, just how dependent the financial system remains on the prompt and effective intervention of the lender of last resort.”

“The events of March 2020 should dispel any illusions that the clearing and collateral mandates of Dodd-Frank are a reliable bulwark against systemic risk, and may contribute to it by baiting the liquidity trap,” he writes.

Pirrong, frequently quoted by major media outlets such as CBS News, The New York Times, The Wall Street Journal, Fortune and others, has taught at the Bauer College since 2003. He has authored four finance monographs, as well as publishing research in major academic journals, and consults with electric utilities, major commodity processors and consumers and commodity exchanges around the world.

By Julie Bonnin